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Value of a Going Concern As we have learned so far into the course that forecasting cash flows into the foreseeable future poses a unique challenge since most enterprises are expected to stay in business for many years. As valuation experts, what we can do in order to come up with a reasonably accurate valuation of a business that is expected to continue for long time? What are the different alternative methodologies that can be applied to meet this challenge? Social Security as a Valuation Problem One of the bigger political "footballs" of early 2005 concerned revising Social Security. Projections abounded -- that nobody refuted -- that the system would start being in net cash outflow by 2017 (give or take a year or two) and go broke by 2042 (again, give or take a year or two). Politics may have tabled the topic for a while, but it is useful analytically. Let me pose two questions. First, how can we analyze the Social Security situation as a valuation problem? Second, "Stocks are too risky for Social Security" has been one of the arguments against the proposed private accounts. Do you agree or disagree? Running head: VALUE OF A GOING CONCERN Value of a Going Concern Institutional Affiliation Course Running head: VALUE OF A GOING CONCERN 2 Question 1 i)As valuation experts, we can do the following practices so that we can come up with a reasonable valuation: We should try our level best and avoid perceptions when valuing business assets. Although perception might matter when asset in question is a painting or sculpture, the value of perceptions then has to be supported by facts which show that, the price paid for such an asset promises the expected cash flows to be generated. Valuation experts should not buy assets for emotional reasons. Rather, it should be because of the promising cash flows that will be generated. Also, when purchasing assets, let them pay exactly the amount of the assets. They should not pay more for the asset than it is work. This asset prices should never be justified using a rational that there are other investors who are willing to pay higher prices for the same assets. They should also avoid bias in the evaluation process. Some of the experts have already formed views about the company before they input the figures into the valuation model, that will be used. Their conclusions will reflect the bias they had in their minds. The sources of the bias may be: The companies which experts choose to evaluate, Institutional factors, what other analysts think about the company and many other more reasons Institutions should not base the valuation process on the basis of rewarding or punishing. It will lead to biased outcomes. Running head: VALUE OF A GOING CONCERN 3 Avoid pre-commitments: valuation experts should never take public positions on the firm's value before the process of valuation is complete. Honest Reporting: Analysts should always reveal any bias prior before the results of the analysis is presented. The expert who will be reviewing it will then know at the back of his mind, and will factor the bias while coming up with conclusions. Valuation experts should always make the best estimates. This is because this estimates are not only used at the current time but also in the future. Given the information, they should work to their best to ensure no error is made or no bias in the conclusion. They should also always update the valuations time over time. Even though they may feel comfortable with the estimates made, the value of that particular asset will change over time. This is attributed to a constant flow of new information, both for the firm and the market. This makes the valuation age quickly. ii)Different methodologies used to meet the challenge Relative Valuation In this type of assessment, valuation experts look at how similar assets are priced on the market. Thus, when one wants to determine how much to pay for a house, he/she will go around the neighborhood and ask how much they sell a similar house. In stocks, investors will know if the stock is expensive or cheap by comparing the price of the stock with similar stocks. This method is advantageous in that it is easy and straightforward to relate. Estimates of values can be easily be obtained for firms and assets especially when there are a large number of companies that can be compared to, in the financial markets. Running head: VALUE OF A GOING CONCERN 4 Relative valuation is also a tailor-made for portfolio managers and analyst so as to determine those assets that were undervalued, and can easily get judged on a relative basis. Contingent Claim Valuation A contingent asset refers to an asset that can only pay off under given circumstances. That is if the value of the specific asset in question goes beyond a pre-specified value for a call option. If the value exceed the level pre-specified, then the asset is worth the difference. It can also be if the value of that asset goes below a pre-specified value for a put option. If the value doesn't exceed the difference, then it is not worth it. The advantages of using contingent claim valuation include: Some assets cannot qualify to be valued with conventional valuation models. Main reason attributed to this is that their values depend entirely on their option characteristics. Also, this model yields realistic estimates of asset value. There is also a significant benefit derived from learning and flexibility Question 2 i) A valuation problem may be brought about by two factors. These will include: Quantity of Detail Available. In this, we should ask ourselves, should the social securities provide more details or less? The benefit associated with more detail is that it will give an analyst a chance to make a sound decision. Either to increase the amount to pay or rather reduce it. He can also make better forecasts and predictions on each item. However, more details will results to growing needs for much more inputs, this can result in potential errors hence leading to complicated model. Running head: VALUE OF A GOING CONCERN 5 The Cost of Complexity: The cost associated with complex social security model are: Information Overload: A lot of information does not always results to better analysis. The investors will be overwhelmed by the vast information which can be conflicting hence leading to poor choices in inputs The Black Box Syndrome: The social securities model becomes too complex such that those who analyzes it can no longer understand its internal workings. ii) I disagree. The following are reasons as to why stocks are too risky for social security; The dividend payout by the stock firms is substantially lower. This has led to the governments even taking money from social security trust so that it can pay its outstanding debts and bills. This leaves the government with nothing to invest. The idea of investing in the stock market will only help a few. This is because the stock market doesn't have a high record now. Stock markets have a long way to get to great heights regarding inflation adjusted values. Getting real money to benefit oneself in the trust is a taxing problem. This means that one has to incur a lot of expenses in saving for the future. The government ownership might increase infringement on decisions made by companies. The public, who contribute most, cannot manage large portion of their investments The future of these stock market is not certain. There is a lot of deficit and debt burden of a country, and therefore, the government may at one time decide to use the social security funds to settle part of the debts Running head: VALUE OF A GOING CONCERN References Introduction to Valuation. (2016). Retrieved 17 March 2016, from http://pages.stern.nyu.edu/.../val. Hebeler, H. (2016). MarketWatch: Stock Market News - Financial News. MarketWatch. Retrieved 17 March 2016, from http://www.marketwatch.com Snopek, L. Valuation of Stocks. The Complete Guide to Portfolio Construction and Management, 117-117. 6 Running head: VALUE OF A GOING CONCERN 7